An interesting inbound investment structure into the US was upheld by the US Tax Court.

The structure let Scottish Power “strip” earnings from its US subsidiary, PacifiCorp, during the period 2000 through 2002 by pulling the earnings out of the United States as interest on shareholder capital put in as debt and deduct the interest on the debt in both the United States and the United Kingdom. The company unwound the structure in late 2002 partly in response to a change in US tax regulations that would have caused the interest to be treated as dividends.

Scottish Power acquired PacifiCorp, a US utility, by setting up a chain of three entities and merging the bottom-tier entity into PacifiCorp with PacifiCorp as the surviving company. The PacifiCorp shareholders received $6.9 billion in Scottish Power stock and ADRs traded on the New York Stock Exchange.

The chain of three entities had at the top two wholly-owned UK subsidiaries, NA1 and NA2. Next down the chain was a Nevada general partnership called NAGP that Scottish Power elected to treat as a corporation for US tax purposes but that was viewed as a pass-through entity for tax purposes in the UK.

Immediately below NAGP was a US acquisition company that merged into PacifiCorp.

Scottish Power capitalized NAGP largely with debt. It made two loans for $4.9 billion to NAGP that NAGP used to acquire 75% of the Scottish Power shares used in the merger. The remaining 25% of the shares essentially came down the ownership chain as capital contributions (equity).

The debt was a $4 billion fixed-rate loan at 7.3% interest for a term of 12 years, and a floating-rate loan of $892 million at LIBOR plus 55 basis points for a term of 15 years. Both loans required quarterly payments of interest.

NAGP fell behind immediately and struggled to make interest payments because dividends from PacifiCorp to NAGP fell short of what was needed. Scottish Power converted the floating-rate debt into equity in NAGP in early 2002 after being advised by PricewaterhouseCoopers that it would be hard to support characterization of more than the $4 billion in fixed-rate notes as debt. It converted the fixed-rate debt into equity at the end of 2002.

In 2006, the IRS instructed its agents to challenge use of cross-border hybrid arrangements as a tier I enforcement issue. The IRS challenged $932 million in interest deductions claimed by the consolidated group of NAGP and PacifiCorp in the United States on grounds that the “debt” was in reality equity from the start.

The US Tax Court said in June that the loans in this case were real debt. The companies treated them as such for purposes of securities and other filings. The court reviewed a list of 11 factors that the US appeals court for the 9th circuit — which is where the case will be heard if it is appealed — uses to distinguish debt from equity. It said only one of the factors pointed to equity in the case of the fixed-rate debt and two for the floating-rate debt.

The case is NA General Partnership v. Commissioner. It is the first of a series of cases waiting for court dates involving billions of dollars in interest deductions. The US government has until at least mid-September to appeal.

Keith Martin